Bull by the Horns

by Sheila Bair

  Second, once the market perceives that a bank or thrift is on a failure trajectory, it will start losing franchise value. This means that the longer we wait to resolve an institution, the lower the price we will receive when we sell it off. No one wants to do business with an institution that looks as though it will fail. So valuable business customers leave and find new banking relationships. It becomes more expensive for a failing institution to fund itself. It may have to pay high interest rates to keep even insured deposits. As its access to unsecured lending dries up, it will have to tie up good assets to post as collateral for loans. All those things make a bank unattractive to potential buyers.

  That was precisely what was happening to WaMu. Its valuable deposit franchise was being eroded through massive withdrawals. It was losing business customers and having to turn to more expensive ways to fund itself to meet its obligations. Fortunately, through our public outreach and aggressive media campaign, we were able to stabilize its insured deposits. I thank my lucky stars to this day that notwithstanding the media hysteria, people kept faith in us and left their insured money in the bank. However, stabilizing the insured deposits was a mixed blessing in the case of WaMu, as it increased our exposure significantly.

  WaMu CEO Kerry Killinger called me at the end of July, pleading for help, but there was not much I could do. I instructed our public affairs staff to increase our public information campaign on the West Coast, and we saturated WaMu’s major service areas with ads extolling the FDIC’s long, perfect track record of protecting insured deposits. At Killinger’s request, I also called Christopher Cox, the chairman of the SEC, to complain about a short selling restriction the SEC had just slapped on the shares of the country’s biggest banks. The restriction had stanched the short sales in the stocks of behemoths such as Citigroup and Goldman Sachs, but it had also redirected short-selling activity to the smaller, publicly traded banks such as WaMu, and WaMu’s share price was taking a beating. Depositors saw WaMu’s shares taking a nosedive, and that was scaring them even more. Without taking a position on whether the SEC should restrict short sales, I complained that by protecting only the big institutions, it was creating more downward pressure on the shares of smaller institutions. Cox said that he was generally sympathetic but his commissioners would not support a broader ban. (Of course, the alternative was to remove the short-sale ban completely, but as with so many of the other policies pursued during the crisis, we protected the big guys and let the smaller ones fend for themselves.)

  Frankly, I had little sympathy for Killinger. He had had a chance to sell his institution at a fair price in the spring to a strong acquirer, which would have permanently stabilized his institution. Instead, he had raised speculative capital from a private-equity fund. The market was now telling him that it was not enough to provide confidence in his institution’s solvency. Our examiners were reaching the same conclusion. I told him point-blank that he needed to either go back to his investors and raise more capital or sell the institution. I reminded him of the harshness of our process and the fact that if we stepped in, his shareholders would almost certainly take a complete loss. He had an obligation to them to right his institution. Unfortunately, his primary regulator, the OTS, was not pushing him in the same direction. It was not pushing him at all.

  As WaMu’s problems mounted, I started receiving “gentle” inquiries from both the Fed and the Treasury Department about what we were doing to deal with the situation. I was trying to get our resolutions staff into WaMu to develop a contingency plan in the event that the deposit withdrawals got out of control and we had to have an emergency closing. Of course, we were being met with resistance by the OTS. On July 25, Donald Kohn, the vice chairman of the Board of Governors of the Federal Reserve, contacted me to let me know that Chase CEO Jamie Dimon had been making the rounds with Hank, Ben, and Tim Geithner to let them know of Chase’s continued interest and that Wells Fargo had contacted Janet Yellen, the head of the San Francisco Federal Reserve Bank, to say that they were interested in a potential acquisition of WaMu. That was a huge relief. My nightmare scenario was that we would have a sudden liquidity failure at WaMu and either have to set up an expensive bridge institution or sell it to JPMorgan Chase at a steep loss. If WaMu could not be sold prior to failure, we would at least have two potential acquirers. I didn’t have a lot of personal experience with bank failures, but one lesson I had already learned was we got a much better price for a failed bank if we sold immediately and we had multiple bidders in the confidential auctions that we ran prior to a bank’s failure. If Chase thought it was the only bidder, it could really gouge us. Having Wells in the mix was a real godsend.

  Our strategy was to ask troubled banks to hire an investment adviser and start soliciting bidders’ interest—essentially putting themselves up for sale. For the FDIC, the strategy was about maximizing the probability of desirable outcomes. Frequently, the process would result in an “unassisted” sale, meaning that the bank would find a buyer or investor to acquire or recapitalize the bank without our having to get involved—the best outcome from our perspective. But if the bank was not successful and ended up entering our resolution process, we would have a ready cadre of potential buyers who had already conducted due diligence on the bank and were prepared to make an informed bid. Even so, in this case we were unlikely to get a very good price unless Chase and Wells had the opportunity to conduct due diligence on WaMu prior to making a bid. If they had to bid blind—without the benefit of being able to analyze WaMu’s loans and deposit franchise carefully—both would lowball their bids because of uncertainty about what they were really buying.

  I had already told Killinger when he had called on July 25 what I thought he needed to do. On July 29, I received a message from John Reich informing me that Killinger would be coming to Washington and wanted to give both of us a briefing on WaMu’s capital and liquidity positions. Instead of acting on my request, my guess was that Killinger was going to try to convince us that its condition was sound and it didn’t need to sell itself or raise more capital. Of course, Killinger wanted to have this meeting jointly with his primary regulator, who, he knew, would be sympathetic to his position.

  Our examiners were increasingly convinced, however, that the thrift would fail without significant new capital. I agreed to take the meeting but advised John Reich that I would be bringing two staff members, Sandra Thompson, our head of supervision, and John Corston, the head of our large-bank examination unit. In a strategy meeting with them before the briefing, I told them that we should first hear Killinger out, but then I wanted John to lay out the staff’s supervisory concerns and reiterate our view that WaMu needed to raise capital or sell. I decided to have John, a tough career examiner, make the case, because I knew John Reich would try to personalize our concerns about WaMu’s growing problems to me if I led the discussion. Whether that was strategic on his part or whether he was really blind to WaMu’s problems, I was never sure. But throughout our struggles with OTS on WaMu’s failing condition, John repeatedly tried to denigrate the FDIC’s concerns by suggesting that it was all just an effort on my part to concentrate more power in the FDIC. (As Citigroup’s primary regulator, Tim Geithner would try to use the same strategy against us later as Citi’s condition deteriorated and we felt that more aggressive action was needed on his part.)

  On July 30, we held the meeting in John Reich’s office. Representing WaMu were Kerry Killinger; Thomas Casey, the CFO; and Robert Williams, the treasurer. The group presented an analysis showing an outer range of cumulative losses through 2010 of $31.1 billion. However, even their “high-loss” scenario assumed that the economy would continue growing and the bank would continue to grow its revenues, assumptions that we viewed as unrealistic and indeed laughable now, given how badly the nation plunged into recession and the steep losses WaMu’s mortgage portfolio continues to generate. As scripted, John Corston told the WaMu team as much, then reiterated our view that the institution needed to raise capital or sel
l itself. Those words were barely uttered when John Reich angrily cut him off, stating that his comments were “inappropriate.”

  A few days later, I followed up with an email to John Reich after consulting with Fed Vice Chairman Don Kohn. I told him that I wanted to have further discussions about WaMu contingency planning during an upcoming weekly call held among the principals of the four bank regulators to review conditions at high-risk banks. I told him we needed a contingency plan in the event of a sudden WaMu liquidity failure, and that would have to involve reaching out to potential acquirers.

  Again he responded strongly, opposing the idea of having such a conversation, even among regulators. In an exceptionally argumentative email, he reflected a fundamental misunderstanding of the FDIC’s authorities and responsibilities. That was surprising to me, since he had served as the FDIC vice chairman for several years before being appointed to head the OTS. Indeed, he stated that the “FDIC has no role until the [primary regulator] (OTS) rules on insolvency and the PFR utilizes PCA.” In fact, the FDIC does have backup authority to close an institution, and those grounds can include the institution’s insolvency or inability to meets its liquidity obligations. In short, if a bank runs out of enough cash to meet deposit withdrawal demands or other cash obligations, the FDIC most certainly has authority to close it. Once again, he personalized the discussion, stating that “the FDIC is behaving as some sort of super-regulator—which you and it are not.” Interestingly, he threatened to meet with Ben Bernanke and Hank Paulson to complain, even though both the Fed and Treasury had been nudging us on contingency planning. I forwarded his email to Don Kohn, who responded that Ben would be “glad to talk58 to him, but John won’t like the message.”

  I had no desire to go to war with the OTS. For better or worse, we needed its help in monitoring a number of very sick thrift institutions. So instead of contacting potential acquirers directly, which in retrospect I wish we had done, I held off and kept trying to work through the OTS. We proceeded to downgrade WaMu to troubled status and pressed the OTS to do the same. We also pressed hard for the bank to replace its management and, most important, to hire an investment adviser for help in raising capital or merging with another institution. The two were related, as we did not think that WaMu would be able to interest investors or acquirers on an open-bank basis with the current, poorly regarded management team. However, as the Senate Permanent Subcommittee on Investigations would later document, the OTS was, at best, not on top of the severity of the institution’s problems and the extreme risks it posed to the Deposit Insurance Fund or, at worst, was completely captive to the only remaining major institution that it regulated. Indeed, our internal analysis showed that if WaMu had failed without an acquirer and we were forced to liquidate it, it would have cost us a whopping $40 billion.

  It was not until September 7 that the OTS forced a management change at WaMu. Exasperated, I called the new CEO, Alan Fishman, on his first day at work, to let him know that he needed to take steps to raise capital or sell the institution. I notified him that the FDIC had placed WaMu on our troubled-bank list during the third quarter. That meant that early in November, when we publicly updated our troubled-bank list, we would add another $300 billion in assets, which, of course, everyone in the market would know was WaMu. Amazingly, neither the current WaMu management nor the OTS staff had told him that the FDIC was downgrading WaMu. I notified John Reich of the call after I made it, which prompted his now-famous email to one of his staff stating “I cannot believe the continuing audacity of this woman.” If only OTS had spent as much energy regulating WaMu as it had fighting us, we might have been able to avert a failure.

  But time was running out. The deposit runoff continued, with uninsured money fleeing or being converted into insured accounts. The ratings agencies were downgrading WaMu’s debt to junk or near-junk status, and its stock price continued to plummet. To offset deposit withdrawals, WaMu was offering high-rate, fully insured CDs and borrowing heavily from the FHLB. On the week of September 8, WaMu lost one of its largest commercial depositors, with $800 million in deposits. On September 11, its share price dipped as low as $1.75 a share, and the cost of buying insurance against a WaMu default skyrocketed. Deposit withdrawals for that day hit $1.6 billion. Within a week, deposit withdrawals would be hitting more than $3 billion per day.

  To Fishman’s credit, he did act swiftly to hire an investment adviser as the death watch continued. Working in coordination with Fishman, we also started reaching out directly to potential acquirers, contacting Chase, Wells, and Santander, a large Spanish bank. (Surprisingly, we also heard from Citigroup. I questioned whether Citi was financially strong enough to acquire WaMu, but both the Fed and the OCC—its two primary regulators—said it was strong enough.)

  Chase initially refused to participate in the process. I called Jamie Dimon, at Fishman’s request, and asked him to work with Fishman on an open-bank, unassisted transaction. It was clear that Dimon was more interested in doing a closed-bank resolution. That was, of course, the result we were trying to avoid. I was concerned that he thought we would arrange a deal in the same way that the NY Fed had arranged his acquisition of Bear Stearns. I advised him that if it came to that, we ran a competitive process, and we expected multiple bidders. If he really wanted WaMu, the only way to guarantee the acquisition was to work with Fishman and be the highest open-bank bidder.

  Unfortunately, as bidders came in to look at WaMu’s loans and “kick the tires,” they didn’t like what they saw. One by one, the investors’ interest withdrew—there were simply too many toxic loans on WaMu’s books and too much uncertainty about the scope of the losses. Chase and Citi were the last two to remain in, but when Lehman Brothers filed for bankruptcy on September 15, market conditions worsened significantly and WaMu experienced another $10 billion in deposit withdrawals. It was unlikely that WaMu would survive unless it started borrowing from the Federal Reserve Board’s discount window. However, Fed lending—like FHLB lending—is heavily collateralized, meaning that the more a bank borrows from those sources, the more expensive it becomes for the FDIC to resolve. For that reason, the law prohibits the Fed from lending to a failing institution, and as a matter of courtesy, the Fed typically consults with us before lending to a troubled bank and does so only with our consent.

  As WaMu continued to hemorrhage deposits, David Bonderman reached out to Fed Governor Kevin Warsh for help. Kevin referred the call to Don Kohn, who had been our primary contact on the WaMu situation. Don and I held a conference call with Bonderman on Saturday, September 20, and I was shocked at the combative way Bonderman pressed Don for access to Fed lending. Don held firm. We told Bonderman that he needed to continue with efforts to sell or recapitalize the bank. We also told him that given WaMu’s rapidly deteriorating condition, it had to have firm commitments in place by Sunday evening. The next evening, we received an update from Bonderman. All interested buyers had pulled out. In a last-ditch effort to avert a failure, I told him that if TPG would put in $8 billion of new capital, we believed that would be sufficient to stabilize the institution, but if it could not raise that amount of new capital, we would have to go to Plan B.

  But instead of being willing to commit new capital, Bonderman and the WaMu team had come up with gimmicks and accounting tricks to try to convert outstanding debt into equity. It was highly questionable whether they could execute the plan, since it relied on the cooperation of the debt-holders. Moreover, from the FDIC’s perspective, their plan did little to protect us from loss because the unsecured debt instruments they proposed to convert were subordinate to the FDIC’s claims in a resolution. That is, they were simply rearranging the proverbial deck chairs on the Titanic. In a resolution, unsecured debt and equity are fully available to absorb FDIC losses. The only way to reduce our risk was to put in additional loss-absorbing capital. But TPG did not want to risk any more money, even though it was happy for the government to get in deeper through Fed lending to keep the sick institution afloa
t. As a result, I said no to their gimmicks and accounting tricks and instructed our resolutions staff, led by Jim Wigand, to begin our confidential auction with an eye to closing the thrift on Friday, September 26.

  Throughout the open-bank marketing process, our resolutions staff had carefully stayed away, as was our usual practice. However, once it became clear that there would be no open-bank solution, Jim and his team sprang into action. They worked the phones over the weekend, setting up Monday meetings with Chase, Wells, Santander, and Citi to review the FDIC resolution process in the event that WaMu failed. By Tuesday, it was clear that WaMu would not make it through the week, so we opened our “data room,” which contained bid instructions, and notified the companies that we would be taking bids Wednesday evening.

  However, at the end of the day, only Chase submitted a serious bid. Wells offered to take the deposits and a few of the high-quality assets but would not touch the rest of the portfolio without “significant support59 through loss sharing.” Similarly, Citi would not take the loans without significant FDIC support. In contrast, Chase offered $1.8 billion to purchase all of the assets and all of the deposits, both insured and uninsured. Chase would also fulfill all of WaMu’s obligations to its general creditors. The only stakeholders to take losses would be WaMu’s shareholders (WaMu was wholly owned by its holding company, WMI) and its bondholders. Losses would be absorbed by bondholders and shareholders, not the government.

  Press speculation about WaMu’s imminent failure was becoming more and more intense, and we were concerned that continuing media speculation would only spur additional deposit withdrawals. Indeed, we already had one inquiry from Damian Paletta at The Wall Street Journal saying that he had heard we were auctioning WaMu, but thanks to some fancy footwork by Andrew Gray, he never ran the story. However, we had no desire to tempt fate further, so the OTS moved to close WaMu on a Thursday, one day earlier than our usual Friday closings. The transition was seamless, the deposits were stabilized, and the press coverage was generally favorable and reassuring. The day after the closing—by far the largest in FDIC history—the Dow Jones Industrial Average was up almost 200 points.